Much has been made about President Obama’s efforts to raise taxes on high income individuals in order to fund additional spending programs such as health care, energy, and the stimulus. Critics cry class warfare and complain that the wealthy shouldn’t be punished in order to provide a welfare state. Defenders say that the rich can afford higher taxes without any big impact on their well-being. The bigger concern to me, and one that isn’t getting the attention that it deserves, is this – it won’t work.
Raising taxes on high income individuals will not raise as much money as expected and may raise even less money than before. This top 2% includes business owners, professionals, doctors, lawyers, and anyone in the highest income levels probably has some control over their career and how much they work. They have the option of taking more vacation, retiring earlier, sheltering income, deferring income, or take some other action that reduces the amount of tax revenue that the government takes in. Any reduction in the amount of work done by these people, and therefore their income, will result in lower tax revenues.
The idea behind this is known as the Laffer Curve and it basically argues that work effort is a declining function of tax rates and that there is some tax rate that maximizes the amount of revenue collected. At low tax rates, people work but the government gets very little tax revenue. As tax rates rise, tax revenues will rise but at a decreasing rate. At some point, tax revenues will begin to fall as the reduced work effort dominates the higher tax rate. At extremely high tax rates, people won’t work and no money will be collected. If you wish to draw it, the Laffer Curve looks just like an arch.
The revenue-maximizing tax rate balances the reduced work effort with the higher tax rates. If you are below this point, then raising tax rates will raise tax revenues, but not by as much as expected. If you are beyond this point, then raising tax rates actually reduces tax revenues. Keynesian economists (Democrats) tend to always believe that we are below that point while supply-side economists (Republicans) believe that we are always beyond that point.
I wouldn’t wager a guess as to where we are on the Laffer Curve, but I do know that raising tax rates on the top 2% will not raise the kind of revenue that Obama is hoping for and there is no way to raise more revenue once you are at that optimal tax rate. Therefore, the only way to reduce the deficit is to cut spending, which does not seem to be in the cards given his ambitious plans. The President must remember one thing about Economics – Scarcity exists.